Bank of banks, The Central Bank !

This Blog talks about the role played by Central bank of a Country:

Central bank controls monetary policy of the country. It has power to control money supply in the economy which in turn impacts inflation, employment, interest rates etc. Money circulation in short is ; what amount of currency should be in market. RBI/Fed controls these by impacting some key ratios

These important ratios are mentioned below:

Repo Rate: Whenever the banks have shortage of funds they can borrow from Central Bank(RBI, Federal Reserve). Repo rate is the rate at which banks borrow money from Central Bank. So clearly, a reduction in repo rate means that banks can borrow money at lower rate.

Repo rate is short term for repurchase rate. Repo rate is the discounted rate at which RBI/Fed buys back(repurchases) the government securities from banks to reduce some of the short term liquidity (make sure banks could honor withdrawals of customers) in the market.  Alternatively central bank decides the desired level of money supply and lets the market decide the repo rate. Securities are sold at original market price and interest and a pre-agreed interest rate, called as Repo rate.

Reverse Repo Rate: Reverse repo rate is the rate at which Central bank borrows money from (national) banks. Banks always prefer to lend money to central bank because they get a good interest rate and definitely their money is in safe hands. So an increase in Reverse Repo Rate can cause banks to transfer more money to central bank.

This rate is just opposite of repo rate. Central bank uses this tool when it feels that there is too much money floating in the market. If the reverse repo rate is increased then banks will prefer to keep their money with Central bank which is risk free instead of lending it out.

Reverse repo rate signifies the rate at which central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected. 

Cash Reserve Ratio/ Reserve Ratio / CRR : The required percentage of reserves that banks must hold in cash or deposit at the Federal Reserve / Central Bank. This varies from time to time and is set by the central bank.

If the federal bank fixes the CRR as 10%, this means that all the banks of the country have to keep 10% of the depositors money with them or with Central bank in the form of cash.  All the banks use their depositors money in providing the credit and they try to expand their credit volume to generate higher profit.  In such situation CRR compels banks to keep the fixed amount of money so that they can pay customers in the hour of their need.  This ratio also helps in increasing/decreasing the money supply in the economy.

Central Bank's primary goal is to raise or lower short-term interest rates. In doing this RBI/Fed can indirectly influence demand, which then influences economy. For example, if interest rates are lowered, borrowing money to make purchases becomes less expensive, and people are more motivated to spend money because they can get a better deal on the loan. Spending money, in turn stimulates economic growth, and that's what is expected out of Central Bank. If there are too much money in the economy, however, people spend more money and demand increases at faster rate then supply can match. Price rise too quickly because of shortage of products, and inflation results. If there is too little money in the economy, people don't have excess spending money, and there is little economic growth. Central bank watches economic indicators closely to determine in which direction the economy is going. By forecasting increases in inflation or slow-downs in the economy, Fed/RBI knows whether to increase or decrease the supply of money.

Book Value

Book value gets a lot of attention these days-perhaps because it's such an easy number to find. You see it reported everywhere. People invest in these on the theory that if the book value is $20 a share and the stock sells for $10, they're getting something for half price.

The flaw is that the stated book value often bears little relationship to the actual worth of the company. It often understates or overstates reality by a large margin.

A textile company may have a warehouse full of fabric that nobody wants, carried on the books at $4 a yard. In reality, they couldn't give the stuff away for 10 cents. There's another unwritten rule here: "The closer you get to finished product, the less predictable the resale value". You know how much cotton is worth, but who can be sure about an orange cotton shirt? You know what you can get for a bar of metal, but what is it worth as a floor lamp?

Overvalued assets mentioned in balance sheet are especially treacherous when there's a lot of debt. Let's say that a company shows $400 million in assets and $300 million in debts, resulting in a positive book value of $100 million. You know that debt part is a real number. But if the $400 million in assets will bring only $200 million in a bankruptcy sale, then the actual is a negative $100 million. The company is less than worthless.

When you buy a stock for its book value, you have to have a detailed understanding of what those values really are.

Growth Rate

If you find a business that can get away with raising prices year after year without losing customers ( an addictive product like cigarettes), you’ve got a terrific investment. Philip Morris( Marlboros cigarettes) can increase earnings by lowering costs and especially by raising prices. That’s the growth rate that really counts: earnings.

You couldn’t raise prices the way Philip Morris does in the apparel industry or the fast food industry or else you’d soon be out of business. But Philip Morris gets progressively richer and richer and can’t find enough things to do with the cash that pile up. The company doesn’t have to invest in expensive blast furnaces, and it doesn’t spend a lot to make a little. Moreover, the company’s costs were greatly reduced after the government told cigarette companies they couldn’t advertise on televisions! This one time where there’s so much lose money around that even diworseification hasn’t hurt the shareholders.

One more thing about growth rate: all else being equal, a 20-percent grower selling at 20 times earnings( a p/e of 20) is much better buy than a 10-percent grower selling at 10 times earnings. This may sound like an esoteric pint, but it’s important to understand what happens to the earnings of the faster grower that propels the stock price.

This in a nutshell is the key to the bigbaggers, and why stocks of 20-precent growers produce huge gains in the market, especially over a number of years. It’s no accident that the Wal-Marts and The Limiteds can go up so much in a decade. It’s all based on the arithmetic of compounded earnings.

Dividend

Stocks that pay dividends are often favored over stocks that don’t pay dividends by investors who desire the extra income. The real issues is that, how the dividend, or the lack of dividend, affects the value of a company and the price of its stock over time.

One strong argument in favor of companies that pay dividends is that companies that don’t pay dividends have a sorry history of blowing the money on a string of stupid diworseifications. The bladder theory of corporate finance is: The more cash that builds up in the treasury, the greater the pressure to piss it away. Another argument in favor of dividends-paying stocks is that the presence of the dividends can keep the stock price from falling as far as it would if there were no dividend.

When a stock sells for $20, a $2 per share dividend results in a 10% yield, but drop the stock price to $10, and suddenly you have got a 20% yield. If the investors are sure that the high yield will hold up, they will the stocks just for that. This will put a floor under the stock price.

Then again, the smaller companies that don’t pay dividends are likely to grow much faster because of it. They’re plowing the money into expansion. The reason that companies issue stock in the first place is so that they can finance their expansion without having to burden themselves with debt from bank.

I will take an aggressive grower over a stodgy old dividend-payer any day.

Electric utilities and telephone utilities are the major dividend-payers. In period of slow growth they don’t need to build plants or expand their equipment and the cash piles up. In period of fast growth the dividends are lures to attract the enormous amounts of capital that plant construction requires.

If you do plan to buy a stock for its dividends, find out if the company is going to be able to pay it during recessions and bad times. If a slow grower omits a dividend, you’re stuck with a difficult situation: a sluggish enterprise that has little going for it.

A company with a 20- or 30- year record of regularly raising its dividends is best bet. Heavily indebted companies can never offer the same assurance.

Cash Flow

Cash flow is the amount of money a company takes in as a result of doing business. All companies take in cash, but some have to spend more than others to get it. This is a critical difference.

Let’s say Pig Iron, Inc. sells out its entire inventory of ingots and makes $100 million. That’s good. Then again, Pig iron, Inc. has to spend $80 million to keep the furnaces up-to-date. That’s bad. The first year Pig Iron doesn’t spend $80 million on furnace improvements, it losses business to more efficient competitors. In cases where you have to spend cash to make cash, you aren’t going to get very far. Companies like McDonal’s doesn’t have this problem. That’s why its preferable to invest in companies that don’t depend on capital spending.

There’s no point getting bogged down in calculating cash flow ratios. But if cash flow is ever mentioned as a reason you’re supposed to buy a stock, make sure that it’s free cash flow that they’re talking about. Free cash flow is what’s left over after the normal capital spending is taken out. It’s the cash you’ve taken in that you don’t have to spend.

P/E Ratio

price/earnings ratio, price-earnings multiple, or simply, the multiple.It is simply the ratio between the price and earnings per share of a company.

P/E ratio is a useful measure of whether any stock is overpriced, fairly priced, or underpriced relative to a company’s money making potential. It’s obtained by dividing the current price of the stock by the earnings for prior 12 months or fiscal year.

The P/E ratio can be thought of as the number of years it will take the company to earn back the amount of your initial investments- assuming, of course, that the company’s earnings stay constant. So P/E value 10 says that it will take 10 years to earn your original investment.

The fact that some stocks have P/E’s of 40 and others have P/E’s of 3 tells you that investors are willing to take substantial gambles on the improved future earnings of some companies, while they’re quite skeptical about the future of others. You will be amazed to see the range of P/E values.

You’ll find that the P/E levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between. We shouldn’t be comparing based on P/E value as it makes no sense to compare apples to oranges.

Sometimes you’ll hear that “this company is selling at a discount to the industry” – meaning that its P/E is at a bargain level. Before you buy a stock, you might want to track its P/E ratio back through several years to get a sense of its normal levels. ( New companies, of course, haven’t been around long enough to have such records.) With few exceptions, an extremely high P/E ratio is a handicap to a stock, in same way that extra weight in the saddle is a handicap to a racehorse. A company with a high P/E must have incredible earnings growth to justify the high price that’s been put on stock. It’s a miracle for even a small company to expand enough to justify a P/E of 64.

Company P/E ratios do not exist in a vacuum. The stock market as a whole has its own collective P/E ratio, which is a good indicator of whether the market at large is overvalued or undervalued. If you find that a few stocks are selling at a inflated prices relative to earnings, it’s likely that most stocks are selling at inflated prices relative to earnings.

Interest rates have a large effect on the prevailing P/E ratios, since investor pay more for stocks when interest rates are low and bonds are less attractive. But interest rates aside, the incredible optimism that develops in bull market can drive P/E ratios to ridiculous levels.

The P/E ratio of any company that’s fairly priced will equal its growth rate( growth rate of earnings).

If the P/E of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a good bargain. A company, say, with a growth rate of 12 percent a year and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown. In general, a P/E ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative. If your broker can’t give you a company’s growth rate, you can figure out for yourself by taking the annual earnings from value line or S&P report and calculating the percent increase in earnings from one year to next. That way, you’ll end up with another measure of whether a stock is or is not too pricey.